COLUMN: Taking an interest in the interest rate

The buzzword in economic terms are interest rates; especially this week when it’s announced whether the Monetary Policy Committee of the Reserve Bank (MPC) will increase or cut local interest rates. But, let's take a more in-depth look at how interest rates impact the whole economy and what relationships it enjoys.

The first and most important from a South African perspective is the undeniable link between inflation and the interest rate. This link gains more importance in South Africa because of the South African Reserve Bank that follows an inflation targeting approach as its primary monetary policy, trying to keep inflation stable between 3-6%. Currently, inflation is in and around the 5% mark, but with upward pressures in both the fuel price and the currency, it could make this week’s MPC meeting very interesting.

An easy way to understand the relationship between the interest rate and inflation is that when interest rates rise, it dampens inflation – making it an inverse relationship. This is because people and market players will be discouraged to borrow money in a high-interest environment. Everyone will be more inclined to save money, thus diminishing demand. In turn this leads to lower prices as businesses fight for business and vice versa.

Following close on the relationship between the interest rate and inflation is the interest rate and the exchange rate. Unlike the inverse effect that we have seen between the interest rate and inflation, with the exchange rate the relationship is more direct, with a hike in interest rates bringing with it a stronger exchange rate and vice versa.

Foreigners can earn higher profits by investing their money into foreign government bonds with a higher interest rate. To invest the money in those foreign countries, they must purchase the other country’s currency by selling their own, increasing the demand of the foreign currency, and elevating its value.

From the above, we see that the interest rate has an impact on important factors in the market, but it also has an impact on GDP growth. In principle, the interest rate and economic growth should have an inverse relationship. Thus, the higher the interest rate, the lower the disposable income of households and businesses which would lead to lower production which would ultimately lead to lower growth – and the opposite is also true.

The conundrum that the MPC face is whether to sit on its hands on Thursday when making its interest rate decision or to act. Should inflation be a problem, then a hike will be in the offing.

However, this must be done with caution because although a hike will curb inflation in the short term and give the Rand a brief respite, it could also suppress economic growth which will attract the eyes of rating agencies. There is a delicate balance to be struck and this could be an important MPC meeting.

To catch up on today’s market commentary, have a look at the TreasuryONE blog which is updated daily.